For over 20 years, US beneficiaries of offshore trusts have lived under the cloud created by the US tax code rules for passive foreign investment corporations (PFICs). When, in an act of generosity, a non-US person creates an offshore trust for the benefit of his or her family, the trustee typically invests the trust assets in non-US passive investment companies even if the funds own publicly traded stocks of active operating businesses. As a result of this structure, the beneficiaries who live in the US or later immigrate there could face an unwelcome surprise – a US tax liability on the investment company income and gains – and an interest charge for delayed payment.¹

Such a tax on phantom income is rarely imposed under other rules of US tax law, and it can be avoided when a US person invests directly in a PFIC without the intervening trust, as well as when the same foreign trust invests directly in active operating companies.

When the PFIC tax was introduced in 1986, it called for regulations to address this issue, but no regulations have ever been issued on how US beneficiaries should be taxed when these offshore trusts invest in PFICs. In a welcome development, however, the American College of Trust and Estate Counsel recently made recommendations to the US Treasury (the ACTEC Proposal) as to how these regulations could be drafted to avoid such a tax on phantom income for US beneficiaries while still following the law’s original intention of curtailing offshore tax deferral for investments in PFICs.²US tax practitioners are hopeful that the ACTEC Proposal will lead to a predictable and fair method to tax such beneficiaries.

Importantly, the ACTEC Proposal provides that the US beneficiaries of non-US trusts should not be subject to tax until they receive a distribution from the trust, even if the trust owns stock in PFICs. Upon receiving a trust distribution, the US beneficiary’s tax liability would include taxes and interest charges that are coordinated with both the tax on PFIC distributions and on distributions from non-US trusts.

An important goal of the US tax law is to prevent US persons from holding funds offshore to avoid or defer paying US taxes. US persons pay US income tax on their worldwide income, while non-US persons pay US income tax only on income from US sources. Accordingly, absent any special tax regimes, a US person could invest in a non-US corporation that earned only non-US source income free of US income tax until the US person received a distribution from the corporation or disposed of the stock (at which point it could qualify as long-term capital gains at preferred rates). Likewise, a US person could be a beneficiary of a non-trust that earns only non-US source income free of US tax until distributions were later received.

To prevent this result, US shareholders of PFICs or US beneficiaries of non-US trusts must pay ordinary income tax and an interest charge when a defined event occurs, such as receipt of a trust distribution or a disposition of PFIC stock. The interest charge is imposed to offset the prior deferral of tax. Both the PFICs and non-US trusts tax regimes key on a distribution as the core event for imposing the tax and interest charge. However, these two anti-deferral systems deal with two different kinds of ‘ownership’ – shareholders who have invested directly and beneficiaries who have no direct control over trust investments.

The PFIC system was prompted by the classic case of US persons moving funds offshore by investing in non-US investment companies and is understandably designed around the assumption of outright ownership and investor control. When PFIC shares are sold, or when an ‘excess distribution’ otherwise occurs, the US shareholder pays a tax at the highest rate for ordinary income even on what would otherwise be capital gains (and often without any credit for basis). The interest charge imposed to offset the interim tax deferral is calculated as if the sales proceeds represent corporate income that was earned ratably over the shareholder’s entire holding period (i.e., spread evenly on a daily pro ration) and for which a tax would have been due each year but for the deferral. The PFIC ‘excess distribution’ rules also tax other kinds of dispositions and deemed dispositions, and tax a dividend to the extent it exceeds 125 per cent of the prior years’ level of distributions. As an alternative to the excess distribution regime, a US shareholder can make a ‘qualified electing fund’ (QEF) election that allows the tax to be calculated on a current basis with capital gains character preserved.³ Further, the QEF election allows the US shareholder to postpone paying tax until receiving a distribution or disposing of the PFIC stock, though the tax then due is subject to an interest charge. Thus, under both of these PFIC tax regimes, tax is generally not due until there is a disposition of the stock or a distribution from the corporation, events which the shareholder typically controls.

Trust beneficiaries usually have no such control, and in a typical offshore trust would not even be aware of the PFIC investment or its details. The trust system for taxing accumulation distributions adjusts well to this, taxing only when there is a distribution to a US beneficiary, and imposing an interest charge.⁴ Yet when the trust invests in a PFIC there is a clash of systems. The beneficiary of a discretionary trust often does not have a sufficient ownership interest or knowledge to make a timely QEF election, and on the other hand, the PFIC regime cannot allow trust ownership to be used as a method to shield a PFIC sale or dividend from tax. A distribution is the common tax trigger event for both the PFIC and trust systems in the simple case, but what happens when the distribution from the PFIC is made to the trust and not to the beneficiary? What if, as is typical for a discretionary trust, it is not clear whether the PFIC proceeds will ever go to a US beneficiary, and what if that distribution may not occur for some time?

To what extent, if any, should the trust holding of the PFIC be analogised to a parent-subsidiary relationship where both companies are PFICs (such as a private investment company investing in hedge funds)? Should the tax then be imposed on the ‘shareholder’ (the beneficiary) of the ‘parent’ (the trust) when there is a disposition of ‘subsidiary’ shares or a dividend to the parent (at the trust level)? A problem with this analogy is that the actual US shareholder of a parent corporation can dispose of the parent shares, or make a QEF election. Knowing that the extent of the ownership interest is fixed and not subject to a trustee’s discretion, the US beneficiary often cannot do the same. The fundamental differences arising when trusts own PFICs seem to have been recognised when the law was enacted because the legislative history gives guidance on how regulations should resolve this conflict and it indicates that primacy should be given to the trust system.⁵

In the absence of these regulations, the IRS has apparently tried to require the US beneficiaries of non-US trusts to pay tax under the PFIC regime when the trust receives an excess distribution even if the trust does not make a corresponding distribution to the beneficiaries – if the ‘facts and circumstances’ indicate that the US beneficiaries are the true owners in some sense of the PFIC proceeds.⁶ Without the regulations, the IRS does not have a consistent method for deferring the tax and interest due under the PFIC regime until a US person receives a trust distribution. A ‘facts and circumstances test’ is inherently unpredictable and cannot adjust to the reality that the facts and circumstances, however defined, will change over time while the PFIC tax, and the trust accumulation tax, must be able to identify taxable income over long periods of time since neither system presumes an annual collection of the tax. Instead regulations can be written to impose a tax and an interest charge when distributions are actually made to the US beneficiaries and take into account both the deferral at the trust level and the prior deferral at the PFIC level. That is the genesis of the ACTEC Proposal.

The ACTEC Proposal describes a framework for potential regulations on the interaction between the accumulation distribution regime and the excess distribution rules in the PFIC regime in a manner to preserve the interest charge on the deferred income tax. Under the ACTEC Proposal, the receipt of an excess distribution or disposition of PFIC stock by a non-US trust would not be immediately taxable to the US beneficiaries, assuming it is not distributed in that same year. Instead, the tax and interest charge would be deferred until a US beneficiary receives a distribution from the trust. Upon receiving a trust distribution, the US beneficiary would pay the tax and interest charge that would have been due under the trust accumulation distribution rules if the PFIC excess distribution had been earned by the trust directly, thus integrating it with other trust earnings and taking into account both the PFIC deferral and the subsequent deferral period between the PFIC event in the trust and the date of the distribution to the beneficiary.

While the ACTEC Proposal does not contain actual implementing language for the regulations, the proposal offers an important first step. When the PFIC anti-deferral regime was first enacted, the US Congress stated that the regulations needed to ‘carry out the purposes of the provisions’ should ‘prevent circumvention of the interest charge.’⁷ Importantly, it also stated that ‘the general rules of subchapter J’ (i.e., the accumulation distribution regime) should apply to determine how ‘any stock owned by a trust which is not a grantor trust shall be attributed to the beneficiaries of the trust.’⁸ The ACTEC Proposal is an important first step toward these goals, seeking to preserve the interest charge without taxing beneficiaries on income they may never receive.

It is certainly no easy task to design rules that harmonise the core principles of the PFIC system that are focused on preventing deferral through outright investments in offshore investment company shares, with the trust taxation system that accommodates the reality that beneficiaries are not investors and do not pay taxes until distributions are made. The ACTEC Proposal has now taken up that challenge and identified ways in which that integration can be accomplished.